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February 24, 2012

Could the End of the Inherited IRA Be Near?

If your client inherits an individual retirement account or 401(k) he or she can choose to space the withdrawals over his or her lifetime instead of receiving the funds as a lump sum today, a payment that’s immediately taxable. In this way, the tax advantages of the IRA can continue throughout lifetime (or until the account is depleted).

Stretch IRAs can become even more valuable because, after the original beneficiary dies, the funds in the account can continue to be passed from generation to generation, thus prolonging the tax savings indefinitely.

In an effort to raise tax revenue, the Senate Finance Committee has proposed a measure that would eliminate these benefits by requiring that the funds be withdrawn within five years of inheritance. Because these measures would apply only to individuals dying after 2012, this year may be the last opportunity to defer income tax through the use of a stretch IRA.

The Senate Finance Committee Proposal

The Senate proposal would eliminate the stretch IRA as an estate planning tool, generating approximately $4.6 billion in tax revenue. The proposal would require beneficiaries of inherited IRAs and 401(k)s to liquidate these accounts within five years of receipt and pay the income taxes associated with the funds they receive.

If the proposed Senate measure is passed, the funds received by the beneficiary would be taxed as ordinary income, which could push some beneficiaries into higher tax brackets or increase the percentage of social security income that is taxed. Removing the funds from the IRA would also put them within reach of bankruptcy creditors.

The new rules would apply to people who die in 2013 or thereafter, though exceptions are built into the proposal for the original account owner’s spouse, beneficiaries within 10 years of age of the account owner, the disabled and children (until they reach adulthood).

Though the proposal raises important concerns, many anticipate that the measure will not pass anytime soon. The proposal is not included in the House version of the bill and Sen. Max Baucus, D-Mont., the bill’s strongest proponent, has indicated that he is open to finding other revenue sources.

Inherited IRAs Today

A beneficiary of an inherited IRA can usually choose to either withdraw the funds in one lump sum or receive payments over a number of years. Some 401(k)’s may require that the funds be withdrawn in a lump sum, but if this is the case, the beneficiary can simply roll the funds over into an IRA.

When a beneficiary chooses to stretch the withdrawals out over his or her lifetime, the value of the accounts continues to grow tax-deferred.

Each year, the IRS requires that the beneficiary of an inherited IRA take a “required minimum distribution” from the account. The amount of the minimum distribution is determined by dividing the amount in the account by the beneficiary’s age, which makes the stretch IRA even more valuable as an estate planning tool when the anticipated beneficiaries are younger. However, if the required minimum distribution is not met, the IRS assesses a 50 percent penalty.

Conclusion

Many clients may use inherited IRAs to provide their heirs with financial security far into the future. These vehicles are attractive options for individuals with relatively small account balances, because they can generate substantial gifts for future generations if managed properly. Further, avoiding a lump-sum payment can keep the beneficiary from spending the inheritance quickly, which may be important for clients looking to provide for their children without the expense of creating a trust.

If the proposals currently being discussed are passed, these benefits would be eliminated. While it does not appear that this will happen in the immediate future, the fact that the Senate has made the proposal indicates that the possibility should be considered when making estate-planning decisions.

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